In this article, we will study the two main components that made the burst of a financial crisis particularly likely.
Hyman Minsky (1919-1996) was the first economist to explain why financial crises, not only can happen, but will happen. His theory goes like this: periods of economic stability irrevocably lead to private debt buildup. When everything goes well, lenders tend to systemically underestimate credit risks (the risk that the debtors are not able to repay what they borrowed).
Minsky’s theory got famous because it has been able to explain to a large extent the situation that lead us to the crisis. In other words, Minsky predicted that in a developing economy, prices tend to increase. As you know, we call this phenomenon “inflation”. When prices increase, this makes debtors’ life easier. Let me explain; Imagine that you contracted a debt in t=1 with a nominal value of 1,000$ and that you wage is equal to 5,000$. If you would like to reimburse your debt now, you should spend exactly 1 fifth of your income. Now, imagine that prices in t=2 are twice as big as they were in t=1. Given that the wages are indexed on the level of prices, you now earn 10,000$. That is, you only need to spend one tenth of your income in order to reimburse your debt. It’s magic isn’t it? This mechanism gives incentives to debtors to borrow money when prices are increasing.
This mechanism made the demand of loans before the crisis to expand. More specifically, the housing market in the US was booming. On the other hand, loans were also extremely profitable for banks, giving them every incentives to loosen their credit standards in order to lend even more. To be able to make those additional loans, banks developed a parallel system that one calls the shadow banking. Basically, it allowed banks to lend to people they could not have lent to otherwise. Banks were regrouping these risky loans into financial instruments called CDOs (does this ring a bell?). By the miracle of diversification, the resulting product was assumed to be very low risk (it was not!).
As soon as a certain amount of debt is attained, it is then only a matter of time before something, the burst of a bubble for example, starts the Minsky Moment.